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Are Junk Bonds Too Hot to Handle?

At the credit bubble's frothiest, legions declared that risk was overrated. Securitization, syndication, and all kinds of slicing and dicing, the thinking went, could confer creditworthiness on pretty much any object, animate or otherwise. Then came the debt market implosion. As default rates spiked for speculative junk bonds, all but the most rarefied of corporate issuers were out of luck.

But barely a year after the world nearly ended, junk debt is staging a record resurgence. In 2009 these riskier corporate bonds (rated below investment grade) have so far returned 52%, well north of the previous record of 39% set in 1991. Untrue to form, these high-yield securities have even vastly outperformed equities, more than doubling the Standard & Poor's (MHP) 500-stock index's year-to-date return of 19%. Issuance is surging, and hot money is sluicing in. In other words, caveat creditor.

True, a junk-bond rally makes sense given all the panic selling last year on fears of economic Armageddon. In 2008 high-yield bonds dropped 26%, their worst one-year showing ever. The price of the securities plummeted as yields skyrocketed as high as 22% by November 2008. Issuer defaults, which obliterate junk returns, multiplied as the credit freeze took hold. Accordingly, the high-yield market's spread, or the excess return over Treasuries demanded by investors, surged to a record of more than 19 percentage points. The entire junk-bond market basically closed for business.

But with defaults expected to peak soon, investors have spent the better part of 2009 bidding up junk bonds, abruptly pushing their spread to Treasuries down to 7.5%. "The fact that the world is breathing shows you how mispriced junk was," says Jim Delaney, a veteran bond trader turned credit market strategist.

The mood shift in the junk-bond market owes much to the trillions of dollars' worth of bailouts, backstops, and monetary and fiscal packages, a reality that seems to have been lost on investors' hunt for higher yields amid extraordinarily low short-term interest rates. "The Fed," laments hedge fund guru Jeremy Grantham, "is beating investors into buying junk and other risky assets, a hair-of-the-dog strategy if ever there was one." So ferocious has the stampede into junk been that the bonds now yield less than their two-decade median, according to Leuthold Group, a Minneapolis investment management firm.

CAUTION: DEFAULTSAnother red flag, at least among fixed-income cognoscenti, is that for the first time in five years the default rate for junk bonds now exceeds their spread to Treasuries. All of which suggests investors are ignoring historically high levels of default risk, increasing the chances that the market rally will overheat or even collapse. "We expected high-yield bond yields to come down, but not this fast," Leuthold analysts wrote in an October dispatch, in which the firm urged clients to start taking profits. "We expected a three- to four-year play, not nine months."

But good luck trying to tell a white-hot junk-bond market to chill. According to Dealogic, the current quarter's new junk issuance is tracking at just a bit less than $42 billion—nearly eight times the sales of a year ago. Lipper FMI reports U.S. junk-bond mutual funds are working on their ninth straight week of net inflows: $329 million last week, on top of $237 million the week before. Investors have directed $28 billion to junk funds so far in 2009, more than in any entire year since 1992.

Too far too fast? "It's fairly dangerous right now to be going back in the soup so quickly after where we were," warned Richard Handler, the chief executive of Jefferies Group (JEF), in an Oct. 20 conference call. The investment bank had just quadrupled its bond-trading revenue, thanks in no small part to the junk rally. Not coincidentally, Jefferies also used the occasion to announce a $300 million debt offering of its own.

Farzad is a Bloomberg Businessweek contributor. Follow him on Twitter @robenfarzad.